The well-connected get to play by one set of highly pliable rules, while everyone else must adhere to the much smaller footprint of hard-and-fast rules.

To anyone paying the slightest bit of attention, these remain very uncertain and trying times. On one side of the intellectual divide are the folks who are counting on deflationary forces overwhelming the normal credit-operated machinery of modern life, resulting in an implosion of economic activity. On the other side are those counting on hyperinflation as the most likely outcome of the grand printing experiment currently being conducted across the globe with its epicenter located within the United States.

In the middle of the intellectual divide are people like me, who are leaning slightly toward one view or the other. Not yet committed to any particular outcome, they're tensed and ready to spring in whichever direction necessary, like the last kids left standing in a game of dodge ball.

Some are expecting an imminent recovery (whatever that means), some a long, slow grind downward, and others a rapid, if not chaotic, plunge into new and unwelcome territory of one sort or another.

There are no right or wrong views here. All sides are on equally firm intellectual standing. However, I want to let you know why it is that I lean toward the inflationary line a bit (okay, a lot, by some people's standards) and why I think that a wide-scale, final fiscal collapse is in the cards.

[Despite the bursting of a massive credit bubble,] everything just keeps perking along. What gives?

The answer, I believe, requires us to ask a Zen-like question along the lines of, "What is the sound of one hand clapping?" That question is, "If nobody recognizes a defaulted debt on their balance sheet, does it exist?"

Suppose, for the sake of argument, that there is a world in which banks are allowed by their regulators to pretend their default losses simply do not exist. And, even more outlandishly, some of these banks are allowed to sell heavily damaged loans to their central bank at nearly their full original price.

What does "deflation" mean in such a world? Not much, as it turns out, at least from a monetary perspective, because money is not being destroyed at nearly the rate that would be expected or predicted by the size and rate of the defaults.

This is the world in which we currently live. Trillions in probable and provable losses quietly exist, out of sight, on the balance sheets of the Federal Reserve and other financial institutions. If they ever come out of hiding and onto the books, I think the deflationists will be proven correct beyond all doubt.

But let me ask this: What prevents the authorities from simply storing them out of sight forever? Or at least long enough to allow the wave of liquidity to work its inevitable magic? So far, much to my great surprise, they've managed to do exactly that, with hardly a squeak from the mainstream press (although the blogosphere is on the job, as usual). I am now wondering if they cannot keep this up indefinitely.

While I certainly took some heat from the deflation camp for these comments at the time, my words herald almost exactly what has happened since then. Losses have been ignored, the Fed has dedicated all of its efforts toward repairing bank balance sheets, and nothing really bad has happened to the financial system. Yet.

With the recent revelation that the Fed engaged with companies and banks headquartered here, there, and everywhere in more than 21,000 separate transactions totaling $1.5 trillion, in a successful effort to prevent bad investment decisions from turning into a series of cascading defaults, I think it's safe to say that what should have happened (i.e., deflationary defaults) didn't happen.

WASHINGTON — As financial markets shuddered and then nearly imploded in 2008, the Federal Reserve opened its vault to the world on a scope much wider and deeper than previously disclosed.

Under orders from Congress, the Fed on Wednesday released details of more than 21,000 transactions under the array of emergency lending programs and other arrangements it conjured up in response to the crisis.

At its peak at the end of 2008, the Fed had about $1.5 trillion in outstanding credit on its books. The central bank, in essence, pumped liquidity, the lifeblood of credit markets, into the circulatory system of an economy that was experiencing a potentially fatal heart attack.

At a recent event that I attended, which was heavily populated by political and monetary leadership, the view of most of the money types was that the "extend and pretend" strategy was a good and effective one. Others, like myself, argue that this "mission creep" by the Fed involves taking on too many roles, doing none of them especially well, and risking much, including the Fed's reputation and autonomy (such as they are).

Changing the Rules

The theme here is simple enough: If and whenever the circumstances justify a major response, existing rules will be changed, altered, bent, or broken.

Because of this, I routinely argue that what should happen won't happen, at least not right away, and that there's really no such thing as investing anymore, only speculating -- unless you're a big bank, favored by the Fed, with advance information.

To the first point, what should be happening right now, with consumer credit well below its 2007 peak and the housing market in disarray, is a massive deflationary spiral. Losses should be piling up and swamping bank balance sheets.

Wall Street's biggest banks, rebounding after a government bailout, are set to complete their best two years in investment banking and trading, buoyed by 2010 results likely to be the second-highest ever. Even if this quarter only matches the third, the banks' revenue will top that of any year except 2009.

The surge has come after the five banks took a combined $135 billion from the Treasury Department's Troubled Asset Relief Program and borrowed billions more from the Federal Reserve's emergency-lending facilities in late 2008 and early 2009 following the collapse of Lehman Bros. Holdings Inc. Since then, the firms have benefited from low interest rates and the Fed's purchases of fixed-income securities.

"This is a once-in-a-lifetime opportunity for most of these banks, and I think they've recognized it as that," said Charles Geisst, a finance professor at Manhattan College in Riverdale, New York, who has written about Wall Street's history. "The profits they're making now will allow them to replenish their capital and take care of the other things they need to do."

Obviously, when you or I lose money on a bad investment decision, it's our own tough luck and we have to manage the fallout from it even if it wipes us out. But big banks? They get a free pass to go along with free money, and they're not even required to make a non-binding commitment that they'll try to lose less next time. I would absolutely love the opportunity to borrow money from the government at a low rate and lend it back to the government at a higher rate, but that program is not available to me.

It is not at all clear that the Fed isn't breaking a few rules along the way that supposedly govern what they can and cannot buy. Certainly they are bending the rule that forbids the Fed from directly participating in government debt auctions by turning around and buying that same government paper from big banks only a week after it was sold at auction by the Treasury Department.

So I would invite you to consider that our expectations of what should happen, whatever they might be, should be tempered by the high likelihood that the rules will be changed as much as and whenever needed in order to keep the game working.

So far the deflationary impact that should have arrived by now hasn't, and a big reason why is because the rules have been changed along the way.

Here are some other "rules" that have turned out to be less concrete than they appear in print:

In the world of market trading, a trade is a trade. No backsies. Shortly after the Flash Crash™ happened on May 6, 2010, the NYSE (New York Stock Exchange) stepped in and arbitrarily drew a line above and below which trades that day were "broken" or canceled (effectively treating them as if they had never happened). The move to break trades was historically unprecedented. Many small-time traders felt that where the line was drawn favored big players who could influence exactly where the NYSE decided to wipe out trades. Confidence in the markets took a big hit, both because the Flash Crash happened in the first place (and was never satisfactorily explained, which suggests the root cause could still be in place) and because of the opaque and arbitrary manner in which the NYSE broke trades.

The CTFC (Commodity Futures Trading Commission) has position limits that regulate how many contracts, long or short, any one market participant can hold. At least on paper, anyway. In reality, JPMorgan (JPM) and HSBC (HBC) hold many times the position limit of silver shorts, and the CFTC has known this for years without taking any action besides holding a few meetings on the subject after much public pressure. Undoubtedly if you or I (or the Hunt brothers) were to try to amass a silver position that breached the position limit, we would be immediately and soundly prevented from doing so. Again, there is one set of rules for the big banks and a very different set for everyone else.

High-frequency trading exists where certain participants are allowed to front-run sub-millisecond quotes, sometimes numbering in the tens of thousands per "event" in order to divine price points and scrape pennies from every transaction using non-public data. Submitting a quote without the intention of having it filled is still against the rules, as is the use of non-public data, but the SEC (Securities Exchange Commission) has decided to prosecute a few penny-stock bucket shops instead of the probable culprits of the Flash Crash and provable destroyers of market confidence.

Again, the theme here is that when the circumstances call for it, the rules can and will be amended, ignored, or broken. Count on it. The sub-theme is that the well-connected get to play by one set of highly pliable rules, while everyone else must adhere to the much smaller footprint of hard-and-fast rules.

Conclusion

The worst that might have happened -- a systemic financial breakdown -- did not happen, and we can be thankful for that. But the alternative has had costs that are only now becoming better appreciated. With constant bending of the rules, the only constant was that every bent rule favored the big banks, often uniquely so.

With this special attention given to a favored few, the social mood darkened considerably among US citizens, especially those far removed from the beneficial impacts of the Fed's largesse. Where states are struggling with extremely painful budget deficits measured in the single billions (in most cases), the Fed has been busy printing up and handing out some $75 billion per month to its coziest clients.

While millions of people ran out of extended unemployment benefits and lost houses due to completely fraudulent and illegal banking practices, nothing was ultimately fixed and (seemingly) nobody went to jail or was charged with anything. Small, regional banks without access to unlimited and essentially free capital from the Fed are now forced to compete with big national banks that have been granted an unlimited backstop by the Fed.

This is how too big to fail leads to too small to succeed.

But anything that is unsustainable will someday stop, bent rules or not.

No positions in stocks mentioned.

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